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Still a long road ahead for market recovery

September 2010

The housing market in the US has historically been the backbone of its economy, leading it out of 7 of the last 8 recessions. However through the collapse of the sub-prime mortgage market the US housing market led us into the last recession.

After recovering somewhat in 2009, the fear of another US housing market collapse was recently elevated with reports of plunging sales for both existing and new homes. US existing home sales fell 27.2% in July to its lowest rate in a decade, while US new home sales fell 12.4% in July to its lowest rate in the series’ history dating back to 1963.

This result was significant and the message it sent to the rest of the global economy was even more striking.

This crash in the US housing market came after federal tax credits given to homebuyers were recently removed. The harsh reality is that without the aid of financial stimulus the world economy may battle to recover.

As the uncertainty increases, global stock markets are becoming increasingly sensitive to bad news. The private sector has not picked up the slack as was anticipated and consumer and capital spending is proving sluggish.

Current (mid-August) consensus among market experts has the probability of a "double-dip" recession at around 25%. Whilst still unlikely, investors are fed up with the volatility associated with risky assets and fleeing for safe haven assets such as cash or bonds.

The plunge in investor confidence can be seen in the first 16 trading days in August; the US S&P 500 index averaged 820 million trades per day. This is the lowest average daily volume since 1999, highlighting either a lot of investors are away on holiday or they are simply fleeing the stock market¹.

Further evidence of this is the huge surge of inflows into bond funds. In fact, the amount of money that is flowing into the relative safety of bond funds is poised to exceed the cash that went into stocks during the tech bubble.

Demand is sky high for both government issued Treasury bonds and for high-quality corporate bonds. The higher demand is pushing down borrowing (interest) costs to record lows, leading companies to take advantage of this opportunity to borrow lots of
"cheap debt" – cash at low interest rates.

And aren't they taking advantage! The cheap access to debt, along with record cash levels on company balance sheets is fuelling a global Merger & Acquisition cycle. An increase in Merger & Acquisitions is often seen as a bullish sign by the market and some analysts are hailing this surge.

However, other analysts are saying that this time around it highlights economic weakness in that companies are looking to make profits through acquisition – and subsequent cost cutting – rather than through top-line revenue growth activity (sales growth). If this is the case, it will be a similar story to the cost cutting process that companies undertook in early 2009 to hit profit expectations.

Whether it’s debt in the form of mortgages for homeowners, Treasury securities to fund government's spending plans or companies issuing bonds to fund Merger & Acquisition activities, debt must always be paid back.

With the amount of debt that has been accumulated, shifted and accumulated again, here’s hoping we do not repeat the same mistakes that we have in the past and borrow beyond our means.

¹ www.bespokeinvest.com